Corporate Finance Project

On

Financial System of India: An Overview

Submitted to:

Mr. Yamala Paparao

Faculty of Corporate Finance

Submitted by:

Hemant Verma
Roll no. 58

Semester VII, Section A

B.A. LLB (Hons.)

Submitted on:
05th October, 2017

HIDAYATULLAH NATIONAL LAW UNIVERSITY

Uparwara Post, Abhanpur, New Raipur (C.G.) – 492002

 i

Declaration of Originality
I, Ahmad Ibrahim, have undergone research of the project work titled “Financial System of India:
an Overview”, as a student of Corporate Finance. I hereby declare that this Research Project has
been prepared by the student for academic purpose only, and is the outcome of the investigation
done by me and also prepared by myself under the supervision of Mr. Yamala Paparao, Faculty of
Corporate Finance, Hidayatullah National Law University, Raipur. The views expressed in the
report are personal to the student and do not reflect the views of any authority or any other person,
and do not bind the statute in any manner.
I also declare that this Research Paper or any part thereof has not been or is not being submitted
elsewhere for the award of any degree or Diploma. This report is the intellectual property of the
on the part of student research work, and the same or any part thereof may not be used in any
manner whatsoever in writing.

Hemant Verma
Roll. No. 58
Semester VII, Section A
 ii

Certificate of Originality
This is to certify that Mr. Hemant Verma, Roll Number 58, student of Semester VII, Section A of
B.A.LL.B.(Hons.), Hidayatullah National Law University, New Raipur (Chhattisgarh) has
undergone research of the project work titled “Financial System of India: an Overview”, in partial
fulfillment of the subject of Corporate Finance. His performance in research work is up to the
level.

Place: Naya Raipur ………………………… ……………………………

Date: 05.10.2017 Mr. Yamala Paparao.

(Faculty- Corporate Finance)

 iii

Acknowledgement
I feel highly elated to work on the project “Financial System of India: an Overview”. The practical
realization of the project has obligated the assistance of many persons. Firstly, I express my deepest
gratitude towards Mr. Yamala Paparao, Faculty of Corporate Finance, to provide me with the
opportunity to work on this project. His able guidance and supervision in terms of his lectures were
of extreme help in understanding and carrying out the nuances of this project.

I would also like to thank The University and the Vice Chancellor for providing extensive database
resources in the library and for the internet facilities provided by the University.

Some typography or printing errors might have crept in, which are deeply regretted. I would be
grateful to receive comments and suggestions to further improve this project.

Hemant Verma
Roll. No. 58
Semester VII, Section A
 iv

Table of Contents
1. Declaration i
2. Certificate of Originality ii
3. Acknowledgement iii
4. Introduction 1
5. Research Methodology 2
5.1. Problem of the Study 2
5.2. Rationale 2
5.3. Objectives 2
5.5. Nature of Study 3
5.6. Limitations 3
5.7. Chapterization 3
6. Structure of Indian Financial System 4
7. Growth and Development of the Indian Financial System 5
8. Weakness of the Indian Financial System 8
9. Components of the Indian Financial System 9
10. Conclusion 25
11. Suggestions 27
12. References 29
 1

Introduction
Economic development of a nation, inter alia, depends on the rate of increase in savings and
investments. When there is an increase in income, a part of it is saved and in course of time this
savings is used in productive activities. In the accomplishment of this networking, a well organized
financial system is indispensable. The advent of liberalization in 1992-93 integrated the different
components of financial system and facilitated various new developments and role of finance
become more and more important for economy. This unit highlights role of finance, classification
of finance, financial system and its components, financial intermediaries, financial markets and
their functions. It also presents an overview of electronic banking and ATM services of modern
banks.

A financial system may be defined as a set of institutions, instruments and markets which promotes
savings and channels them to their most efficient use. It consists of individuals (savers),
intermediaries, markets and users of savings (investors). In the worlds of Van Horne, “financial
system allocates savings efficiently in an economy to ultimate users either for investment in real
assets or for consumption”.

According to Prasanna Chandra, “financial system consists of a variety of institutions, markets and
instruments related in a systematic manner and provide the principal means by which savings are
transformed into investments”. Thus financial system is a set of complex and closely interlinked
financial institutions, financial markets, financial instruments and services which facilitate the
transfer of funds. Financial institutions mobilise funds from suppliers and provide these funds to
those who demand them. Similarly, the financial markets are also required for movement of funds
from savers to intermediaries and from intermediaries to investors. In short, financial system is a
mechanism by which savings are transformed into investments.
 2

Research Methodology

Problem of the Study

The economic growth model on which concentration of all the countries have been was only on
the increase of the GDP and per capita income. With time countries have realized that it is not the
perfect model to follow but the best model is the model of sustainable development. The cost of
the economic growth model led to some severe irreversible social, environmental and economic
costs. The transition to a model of green economy for sustainable development, modes of having
a green economy and whether it can be applied or not is the question of this project.

Rationale

As a result of increase in the drastic negative issues faced by the planet because of the unregulated
development throughout, has to be regulated. Now, since we cannot put an end to the trade and
development, we need to look out for measures to control the same. We desire to strike a
harmonious balance between the environment and the development in the trade and development.
To achieve the desired target, we look towards green economy. This project tries to answer how
much possible is it to make a transition towards green economy and also the means by which it
can be done. The attempt to show what will be the impact is also made.

Objectives

The objectives of this project are:

1. To study in brief what is Green Economy.

2. To deal with the pronouncements and disciplines of WTO and UN relating to Environment
and protection.
3. To study in detail the concept of shifting from the traditional economy to green economy
for sustainable development.
4. To understand the impact of the transition to green economy and the implications.
 3

Nature of Study

The nature of the study in this project is doctrinal and is primarily descriptive and analytical. This
project is largely based on primary sources of data such as cases, however secondary & electronic
sources of data have been referred to a great extent. Case laws, journals & other reference as guided
by faculty of International Trade Law are primarily used for the completion of this project.

Limitations of the Study

Due to paucity of time and resources the author has dealt in brief the Indian Financial System. A
detailed account though desirable is not done because of time constraints. Various reports and
articles have been taken into account showing the approach of government to deal and modify the
Financial System but not each and every article and reports are analyzed in their entirety. Various
journals have been dealt in the project but only the relevant part has been analyzed.

Chapterization

This project has been divided into 6 chapters.

Chapter 1 comprises of Introduction and Research Methodology of the project.

Chapter 2 shows Structure of Indian Financial System.

Chapter 3 of the project deals with the Growth and Development of the Indian Financial System.

Chapter 4 points out the Weaknesses of the Indian Financial System.

Chapter 5 deals in detail with the Components of the Indian Financial System.

At last, Chapter 6 concludes this project along Suggestions and references.

Structure of Indian Financial System

 4

Financial structure refers to shape, components and their order in the financial system. The Indian
financial system can be broadly classified into formal (organised) financial system and the
informal (unorganised) financial system1. The formal financial system comprises of Ministry of
Finance, RBI, SEBI and other regulatory bodies. The informal financial system consists of
individual money lenders, groups of persons operating as funds or associations, partnership firms
consisting of local brokers, pawn brokers, and non-banking financial intermediaries such as
finance, investment and chit fund companies.2 The formal financial system comprises financial
institutions, financial markets, financial instruments and financial services. These constituents or
components of Indian financial system may be briefly discussed as below:

Growth and Development of Indian Financial System

1
According to the official definition, the unorganized sector is comprised of: 1) all the enterprises except units
registered under Section 2m(i) and 2m(ii) of the Factories Act, 1948, and Bidi and Cigar Workers (condition of
employment) Act, 1966; and 2) all enterprises except those run by the government (central, state and local bodies) or
Public Sector Enterprises.
2
Allen, F., R. Chakrabarti, S. De, J. Qian and M. Qian, 2006, “Financing Firms in India”, Working paper, The Wharton
School.
 5

At the time of independence in 1947, there was no strong financial institutional mechanism in the
country. The industrial sector had no access to the savings of the community. The capital market
was primitive and shy. The private and unorganized sector played an important role in the
provision of liquidity. On the whole, there were chaos and confusions in the financial system. After
independence, the government adopted mixed economic system. A scheme of planned economic
development was evolved in 1951 with a view to achieve the broad economic and social objective.
The government started creating new financial institutions to supply finance both for agricultural
and industrial development.3 It also progressively started nationalizing some important financial
institutions so that the flow of finance might be in the right direction. The following developments
took place in the Indian financial system:

 Nationalisation of financial institutions: RBI, the leader of the financial system, was
established as a private institution in 1935. It was nationalized in 1949. This was followed
by the nationalisation of the Imperial bank of India. One of the important mile stone in the
economic growth of India was the nationalisation of 245 life insurance Corporation in
1956. As a result, Life Insurance Corporation of India came into existence on 1st
September, 1956. Another important development was the nationalisation of 14 major
commercial banks in 1969. In 1980, 6 more banks were nationalized. Another landmark
was the nationalisation of general insurance business and setting up of General Insurance
Corporation in 1972.

 Establishment of Development Banks: Another landmark in the history of development

of Indian financial system is the establishment of new financial institutions to supply
institutional credit to industries. In 1949, RBI undertook a detailed study to find out the
need for specialized institutions. The first development bank was established in 1948. That
was Industrial Finance Corporation of India (IFCI). In 1951, Parliament passed State
Financial Corporation Act. Under this Act, State Governments could establish financial
corporation’s for their respective regions.4 The Industrial Credit and Investment

3
Kumbhakar, S.C. and Sarkar, S., 2003, “Deregulation, Ownership, and Productivity
Growth in the Banking Industry: Evidence from India”, Journal of Money, Credit,
and Banking, 35, 403-424.
4
Koeva, Petya, 2003, “The Performance of Indian Banks during Financial Liberalization”, IMF Working Paper No.
03/150.
 6

Corporation of India (ICICI) were set up in 1955. It was supported by Government of India,
World Bank etc. The UTI was established in 1964 as a public sector institution to collect
the savings of the people and make them available for productive ventures. The Industrial
Development Bank of India (IDBI) was established on 1st July 1964 as a wholly owned
subsidiary of the RBI. On February 16, 1976, the IDBI was delinked from RBI. It became
an independent financial institution. It co-ordinates the activities of all other financial
institutions. In 1971, the IDBI and LIC jointly set up the Industrial Reconstruction
Corporation of India with the main objective of reconstruction and rehabilitation of sick
industrial undertakings. The IRCI was converted into a statutory corporation in March 1985
and renamed as Industrial Reconstruction Bank of India. Now its new name is Industrial
Investment Bank of India (IIBI). In 1982, the Export-Import Bank of India (EXIM Bank)
was set up to provide financial assistance to exporters and importers. On April 2, 1990 the
Small Industries Development Bank of India (SIDBI) was set up as a wholly owned
subsidiary of IDBI. The SIDBI has taken over the responsibility of administrating the Small
Industries Development Fund and the National Equity Fund.5

 Establishment of Institution for Agricultural Development: In 1963, the RBI set up the
Agricultural Refinance and Development Corporation (ARDC) to provide refinance
support to banks to finance major development projects, minor irrigation, farm
mechanization, land development etc. In order to meet credit needs of agriculture and rural
sector, National Bank for Agriculture and Rural Development (NABARD) was set up in
1982. The main objective of the establishment of NABARD is to extend short term,
medium term and long term finance to agriculture and allied activities.

 Establishment of institution for housing finance: The National Housing Bank (NHB)
has been set up in July 1988 as an apex institution to mobilise resources for the housing
sector and to promote housing finance institutions.6

5
Mukherjee, K., S. C. Ray and S. M. Miller, 2001, Productivity growth in large US commercial banks: The initial
post-deregulation experience, Journal of Banking & Finance, Vol 25, Issue 5, Pages 913-939.
6
1998, “Law and Finance,” Journal of Political Economy, 106, 1113-55. V Leuz, C., Nanda, D., and Wysocki, P.
2003. “Earnings Management and Investor Protection: An International Comparison”. Journal of Financial
Economics, 69:
505-527.
 7

 Establishment of Stock Holding Corporation of India (SHCIL): In 1987, another

institution, namely, Stock Holding Corporation of India Ltd. was set up to strengthen the
stock and capital markets in India. Its main objective is to provide quick share transfer
facilities, clearing services, support services etc. to investors.7

 Establishment of mutual funds and venture capital institutions: Mutual funds refer to
the funds raised by financial service companies by pooling the savings of the public and
investing them in a diversified portfolio. They provide investment avenues for small
investors who cannot participate in the equities of big companies. Venture capital is a long
term risk capital to finance high technology projects. The IDBI venture capital fund was
set up in 1986. The ICICI and the UTI have jointly set up the Technology Development
and Information Company of India Ltd. in 1988 to provide venture capital.8

 New Economic Policy of 1991: Indian financial system has undergone massive changes
since the announcement of new economic policy in 1991. Liberalization, Privatization and
Globalization has transformed Indian economy from closed to open economy. The
corporate industrial sector also has undergone changes due to delicensing of industries,
financial sector reforms, capital markets reforms, disinvestment in public sector
undertakings etc.

Since 1990s, Government control over financial institutions has diluted in a phased manner.
Public or development financial institutions have been converted into companies, allowing
them to issue equity/bonds to the public. Government has allowed private sector to enter into
banking and insurance sector. Foreign companies were also allowed to enter into ins urance
sector in India. 9

7
Ibid.
8
Ibid.
9
Sarkar Jayati and Subrata Sarkar, 2003 “Liberalization, Corporate Ownership and Performance: The Indian
Experience” (with Subrata Sarkar), in Corporate Capitalism in South Asia edited by Ananya Mukherjee-Reed,
International Political Economy Series (ed by Timothy M. Shaw) published by Macmillan Press, UK.
 8

Weakness of Indian Financial System

Even though Indian financial system is more developed today, it suffers from certain weaknesses.
These may be briefly stated below:10

 Lack of co-ordination among financial institutions: There are a large number of

financial intermediaries. Most of the financial institutions are owned by the government.
At the same time, the government is also the controlling authority of these institutions. As
there is multiplicity of institutions in the Indian financial system, there is lack of co-
ordination in the working of these institutions.
 Dominance of development banks in industrial finance: The industrial financing in
India today is largely through the financial institutions set up by the government. They get
most of their funds from their sponsors. They act as distributive agencies only. Hence, they
fail to mobilise the savings of the public. This stands in the way of growth of an efficient
financial system in the country.
 Inactive and erratic capital market: In India, the corporate customers are able to raise
finance through development banks. So, they need not go to capital market. Moreover, they
do not resort to capital market because it is erratic and inactive. Investors too prefer
investments in physical assets to investments in financial assets.
 Unhealthy financial practices: The dominance of development banks has developed
unhealthy financial practices among corporate customers. The development banks provide
most of the funds in the form of term loans. So there is a predominance of debt in the
financial structure of corporate enterprises. This predominance of debt capital has made
the capital structure of the borrowing enterprises uneven and lopsided. When these
enterprises face financial crisis, the financial institutions permit a greater use of debt than
is warranted. This will make matters worse.
 Monopolistic market structures: In India some financial institutions are so large that
they have created a monopolistic market structures in the financial system. For instance,
the entire life insurance business is in the hands of LIC. The weakness of this large structure

10
Hazra, Arnab K. and Maja Micevska, 2004, “The Problem of Finacial Congestion: Evidence from Indian Financial
System”, Working Paper, University of Bonn.
 9

is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would

retard the development of the financial system of the country itself.
 Other factors: Apart from the above, there are some other factors which put obstacles to
the growth of Indian financial system. Examples are:

a. Banks and Financial Institutions have high level of NPA.

b. Government burdened with high level of domestic debt.

c. Cooperative banks are labeled with scams.

d. Investors confidence reduced in the public sector undertaking etc.

e. Financial illiteracy.

Components of Financial System in India

I. Financial Institutions/Intermediaries

Financial institutions are the participants in a financial market. They are business organizations
dealing in financial resources. They collect resources by accepting deposits from individuals and
institutions and lend them to trade, industry and others. They buy and sell financial instruments.
They generate financial instruments as well. They deal in financial assets. They accept deposits,
grant loans and invest in securities.

The term financial intermediary may refer to an institution, firm or individual who performs
intermediation between two or more parties in financial context. Typically the first party is a
provider of a product or service and the second party is a consumer or customer. A financial
intermediary is typically an institution that facilitates the channeling of funds between lenders and
borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as
banks), and then that institution in turn gives those funds to spenders (borrowers). This may be in
the form of loans or mortgages.11

11
Mukherjee, Paramita, Suchismita Bose and Dipankar Coondoo, 2002, ‘Foreign Institutional Investment in the Indian
Equity Market’, Money and Finance, April- September.
 10

Financial institutions or financial intermediaries act as half-way houses between the primary
lenders and the final borrowers. They borrow funds (or accept deposits) from those who are willing
to give up their current purchasing power and lend to (or buy securities from) those who require
the funds for meeting the current expenditures. Financial institutions are generally divided into
two categories - banks and non-bank financial institutions. The main difference is that the banks
possess while the non-bank do not possess the demand deposits or credit creating power. Banking
institutions can be divided into various categories according to their functions i.e. commercial
banks, development banks, investment banks, cooperative banks and regional rural banks. On the
other hand, non-banking finance companies can be categorized as loan and finance companies,
leasing and hire-purchase companies, housing finance companies, insurance companies, chit funds
and mutual benefit funds and other residual finance companies

Financial institutions are the business organizations that act as mobilises of savings and as
purveyors of credit or finance. This means financial institutions mobilise the savings of savers and
give credit or finance to the investors. They also provide various financial services to the
community. They deal in financial assets such as deposits, loans, securities and so on. On the basis
of the nature of activities, financial institutions may be classified as: (a) Regulatory and
promotional institutions, (b) Banking institutions, and (c) Non-banking institutions.

1. Regulatory and Promotional Institutions: Financial institutions, financial markets, financial

instruments and financial services are all regulated by regulators like Ministry of Finance, the
Company Law Board, RBI, SEBI, IRDA, Dept. of Economic Affairs, Department of Company
Affairs etc. The two major Regulatory and Promotional Institutions in India are Reserve Bank of
India (RBI) and Securities Exchange Board of India (SEBI). Both RBI and SEBI administer,
legislate, supervise, monitor, control and discipline the entire financial system. RBI is the apex of
all financial institutions in India.12 All financial institutions are under the control of RBI. The
financial markets are under the control of SEBI. Both RBI and SEBI have laid down several
policies, procedures and guidelines. These policies, procedures and guidelines are changed from
time to time so as to set the financial system in the right direction.

12
Bhaumik, Sumon K. and Jenifer Piesse, 2003, “Are Foreign Banks Active in Emerging Credit Markets? Evidence
from the Indian Banking Industry”, Working Paper, Queen’s University, Belfast.
 11

2. Banking Institutions: Banking institutions mobilise the savings of the people. They provide a
mechanism for the smooth exchange of goods and services. They extend credit while lending
money. They not only supply credit but also create credit. There are three basic categories of
banking institutions. They are commercial banks, co-operative banks and developmental banks.13

3. Non-banking Institutions: The non-banking financial institutions also mobilize financial

resources directly or indirectly from the people. They lend the financial resources mobilized. They
lend funds but do not create credit. Companies like LIC, GIC, UTI, Development Financial
Institutions, Organisation of Pension and Provident Funds etc. fall in this category. Non-banking
financial institutions can be categorized as investment companies, housing companies, leasing
companies, hire purchase companies, specialized financial institutions (EXIM Bank etc.)
investment institutions, state level institutions etc. Financial institutions are financial
intermediaries. They intermediate between savers and investors. They lend money. They also
mobilise savings.

II. Financial Markets

Financial markets are another part or component of financial system. Efficient financial markets
are essential for speedy economic development. The vibrant financial market enhances the
efficiency of capital formation. It facilitates the flow of savings into investment. Financial markets
bridge one set of financial intermediaries with another set of players. Financial markets are the
backbone of the economy. This is because they provide monetary support for the growth of the
economy. The growth of the financial markets is the barometer of the growth of a country’s
economy. 14

Financial markets are markets which cater to the financial needs of individuals, firms and
institutions required for short as well as for long period. Financial markets could also mean:

 The mechanism that facilitate the parking of surplus money of individuals, firms and
investment bankers to earn return.

13
Bhattacharyya, A., Lovell, C.A.K. and Sahay, P., 1997, “The Impact of Liberalization on the Productive Efficiency
of Indian Commercial Banks”European Journal of Operational Research, 98, 332-345.
14
Agarwal, Manish and Aditya Bhattacharya, 2006. “Mergers in India – a Response to Regulatory Shocks”, Emerging
Markets Finance and Trade, 42(3), pp. 46-65.
 12

 Organizations that facilitate the trade in financial products i.e. Stock exchanges facilitate
the trade in stocks, bonds and warrants.

Hence, financial market is a mechanism that allows people to easily buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods),
and other fungible items of value at low transaction costs and at prices that reflect the efficient
market hypothesis. Financial markets facilitate:

 The raising of capital (in the capital markets);

 The transfer of risk (in the derivatives markets); and
 International trade (in the currency markets).

Financial market deals in financial securities (or financial instruments) and financial services.
Financial markets are the centres or arrangements that provide facilities for buying and selling of
financial claims and services. These are the markets in which money as well as monetary claims
is traded in. Financial markets exist wherever financial transactions take place. Financial
transactions include issue of equity stock by a company, purchase of bonds in the secondary
market, deposit of money in a bank account, transfer of funds from a current account to a savings
account etc.15 The participants in the financial markets are corporations, financial institutions,
individuals and the government.16 These participants trade in financial products in these markets.
They trade either directly or through brokers and dealers. In short, financial markets are markets
that deal in financial assets and credit instruments.

Functions of Financial Markets:

The main functions of financial markets are outlined as below:

1. To facilitate creation and allocation of credit and liquidity.

2. To serve as intermediaries for mobilisation of savings.
3. To help in the process of balanced economic growth.
4. To provide financial convenience.

15
Bose, Suchismita, 2005. “Securities Markets Regulation: Lessons from US and Indian
Experience”, Money and Finance, Jan-June, 83-124.
16
Ghosh, A., 2006, “Determination of Executive Compensation in An Emerging Economy: Evidence from India”,
Emerging Markets Finance and Trade, Vol. 42,
No. 3, 66-90.
 13

5. To provide information and facilitate transactions at low cost.

6. To cater to the various credits needs of the business organisations.

Classification of Financial Markets:

There are different ways of classifying financial markets. There are mainly five ways of classifying
financial markets.

1. Classification on the basis of the type of financial claim: On this basis, financial markets may
be classified into debt market and equity market.

Debt market: This is the financial market for fixed claims like debt instruments.

Equity market: This is the financial market for residual claims, i.e., equity instruments.17

2. Classification on the basis of maturity of claims: On this basis, financial markets may be
classified into money market and capital market.

Money market: A market where short term funds are borrowed and lend is called money market.
It deals in short term monetary assets with a maturity period of one year or less. Liquid funds as
well as highly liquid securities are traded in the money market. Examples of money market are
Treasury bill market, call money market, commercial bill market etc. The main participants in this
market are banks, financial institutions and government. In short, money market is a place where
the demand for and supply of short term funds are met.

Capital market: Capital market is the market for long term funds. This market deals in the long
term claims, securities and stocks with a maturity period of more than one year. It is the market
from where productive capital is raised and made available for industrial purposes.18 The stock
market, the government bond market and derivatives market are examples of capital market. In
short, the capital market deals with long term debt and stock.

17
Mukherjee, Paramita, Suchismita Bose and Dipankar Coondoo, 2002, ‘Foreign Institutional Investment in the Indian
Equity Market’, Money and Finance, April-September.
18
Government of India, Ministry of Finance, 2005, Report of the Expert Group on Encouraging FII Flows and
Checking the Vulnerability of Capital Markets to Speculative Flows, New Delhi, November.
 14

3. Classification on the basis of seasoning of claim: On this basis, financial markets are classified
into primary market and secondary market.

Primary market: Primary markets are those markets which deal in the new securities. Therefore,
they are also known as new issue markets. These are markets where securities are issued for the
first time. In other words, these are the markets for the securities issued directly by the companies.
The primary markets mobilize savings and supply fresh or additional capital to business units. In
short, primary market is a market for raising fresh capital in the form of shares and debentures.

Secondary market: Secondary markets are those markets which deal in existing securities. Existing
securities are those securities that have already been issued and are already outstanding. Secondary
market consists of stock exchanges. Stock exchanges are self regulatory bodies under the overall
regulatory purview of the Govt. /SEBI.19

4. Classification on the basis of structure or arrangements: On this basis, financial markets can be
classified into organised markets and unorganized markets.

Organised markets: These are financial markets in which financial transactions take place within
the well established exchanges or in the systematic and orderly structure.

Unorganised markets: These are financial markets in which financial transactions take place
outside the well established exchange or without systematic and orderly structure or arrangements.

5. Classification on the basis of timing of delivery: On this basis, financial markets may be
classified into cash/spot market and forward / future market.

Cash / Spot market: This is the market where the buying and selling of commodities happens or
stocks are sold for cash and delivered immediately after the purchase or sale of commodities or
securities.

Forward/Future market: This is the market where participants buy and sell stocks/commodities,
contracts and the delivery of commodities or securities occurs at a pre-determined time in future.

19
Supra at 14.
 15

6. Other types of financial market: Apart from the above, there are some other types of financial
markets. They are foreign exchange market and derivatives market.

Foreign exchange market: Foreign exchange market is simply defined as a market in which one
country’s currency is traded for another country’s currency. It is a market for the purchase and sale
of foreign currencies.

Derivatives market: The derivatives are most modern financial instruments in hedging risk. The
individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to
accept the risk for a price. A common place where such transactions take place is called the
derivative market. It is a market in which derivatives are traded. In short, it is a market for
derivatives. The important types of derivatives are forwards, futures, options, swaps, etc.

However, the financial markets are broadly and commonly divided into two types -

Money Market - The money market is the market which deals with short-term funds in the
economy. It refers to the institutional arrangements facilitating borrowings and lending of short-
term funds. It is the market in which financial institutions, mainly banks lend and borrow money
or near money assets from each other, trade in securities, treasury bills and other financial
instruments such as certificates of deposits or enter into agreements such as Repos and Reverse
Repos. In a money market, funds can be borrowed for a short period varying from a day, a week,
a month or 3 to 6 months, sometimes up to one year and against different types of instruments,
such as, treasury bills, bill of exchange, bankers’ acceptances, and bonds etc., called “near money”.

The basic functions of money market are-

 To provide efficient mechanism for adjustment of liquidity positions of commercial banks,

non-bank financial institutions, business firms and other investors.
 To provide a platform for the central bank of the country to control and manage the money
supply and the liquidity in the economy.
 To bridge between short term surpluses and deficits.
 To provide a realistic price for short term money.

Participants who enters into the transactions in the money market are-
 16

1. Central Government
2. State Government
3. Public Sector Undertakings
4. Scheduled Commercial Banks
5. Private Sector Companies
6. Provident Funds
7. Life Insurance Companies
8. General Insurance Companies
9. Mutual Funds
10. Non-banking Financial Companies
11. Primary Dealers

Capital Market - The term capital market refers to the institutional arrangements for facilitating
the borrowing and lending of long-term funds. A capital market may be defined as an organised
mechanism for effective and efficient transfer of money or financial resources from the investing
parties, i.e. individuals or institutional savers to the entrepreneurs engaged in industry or commerce
and that would either be in the private or public sectors of an economy. All the long term capital
needs are met by the capital market. Capital market is a central coordinating and directing
mechanism for free and balanced flow of financial resources into the economic system operating
in a country.

Functions of Capital market;

1. Provides a platform for raising long term funds

2. Acts as an intermediary between buyers and sellers of securities
3. Facilitates an organized trading mechanism for stock and securities.
4. Provides a standard price for the securities.
5. Nexus between savings and investment.

III. Financial Instruments/Assets/Securities.

 17

Financial instruments are the financial assets, securities and claims. They may be viewed as
financial assets and financial liabilities. Financial assets represent claims for the payment of a sum
of money sometime in the future (repayment of principal) and/or a periodic payment in the form
of interest or dividend. Financial liabilities are the counterparts of financial assets. They represent
promise to pay some portion of prospective income and wealth to others. Financial assets and
liabilities arise from the basic process of financing. Some of the financial instruments are tradable/
transferable. Others are non tradable/non-transferable. Financial assets like deposits with banks,
companies and post offices, insurance policies, NSCs, provident funds and pension funds are not
tradable. Securities (included in financial assets) like equity shares and debentures, or government
securities and bonds are tradable. Hence they are transferable. In short, financial instruments are
instruments through which a company raises finance.20

The financial instruments may be capital market instruments or money market instruments or
hybrid instruments. The financial instruments that are used for raising capital through the capital
market are known as capital market instruments. These include equity shares, preference shares,
warrants, debentures and bonds. These securities have a maturity period of more than one year.

The financial instruments that are used for raising and supplying money in a short period not
exceeding one year through money market are called money market instruments. Examples are
treasury bills, commercial paper, call money, short notice money, certificates of deposits,
commercial bills, money market mutual funds.

Hybrid instruments are those instruments which have both the features of equity and debenture.
Examples are convertible debentures, warrants etc.

Financial instruments may also be classified as cash instruments and derivative instruments. Cash
instruments are financial instruments whose value is determined directly by markets. Derivative
instruments are financial instruments which derive their value from some other financial
instrument or variable.

Financial instruments can also be classified into primary instruments and secondary instruments.
Primary instruments are instruments that are directly issued by the ultimate investors to the

20
La Porta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2006. “What Works in Securities Laws?”
Journal of Finance 61 (1), 1-32.
 18

ultimate savers. For example, shares and debentures directly issued to the public. Secondary
instruments are issued by the financial intermediaries to the ultimate savers. For example, UTI and
mutual funds issue securities in the form of units to the public.

Characteristics of Financial Instruments

The important characteristics of financial instruments may be outlined as below:

1. Liquidity: Financial instruments provide liquidity. These can be easily and quickly converted
into cash.
2. Marketing: Financial instruments facilitate easy trading on the market. They have a ready
market.
3. Collateral value: Financial instruments can be pledged for getting loans.
4. Transferability: Financial instruments can be easily transferred from person to person.
5. Maturity period: The maturity period of financial instruments may be short term, medium term
or long term.
6. Transaction cost: Financial instruments involve buying and selling cost. The buying and selling
costs are called transaction costs. These are lower.
7. Risk: Financial instruments carry risk. This is because there is uncertainty with regard to
payment of principal or interest or dividend as the case may be.
8. Future trading: Financial instruments facilitate future trading so as to cover risks due to price
fluctuations, interest rate fluctuations etc.
The financial instruments are the claims to money and perform some functions of money. Financial
instruments denote any form of funding medium - mostly those used for borrowing and investing
in financial markets, e. g. bills of exchange, bonds, etc. They have high degree of liquidity but are
not as liquid as money. 21

From the intermediary point of view, financial instruments can be categorized into two types -

Primary or Direct Instruments - They are the financial claims against real-sector units created
by real-sector units as ultimate borrowers for raising funds to finance their deficit spending, they
are the obligation of ultimate borrowers. The examples are bills, bonds, equities, book debts etc.

21
National Stock Exchange of India ‘Indian Securities Market- A Review’ 2006.
 19

Secondary or Indirect Instruments - They are financial claims issued by financial institutions
against themselves to raise funds from the public. These assets are the obligations of the financial
institutions. The examples are bank deposits, life insurance policies, units of Unit Trust of
India etc.

Financial instruments can also be categorized by form, depending on whether they are cash
instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by markets. They
can be divided into securities, which are readily transferable, and other cash instruments such as
loans and deposits, where both borrower and lender have to agree on a transfer.

Derivative instruments are financial instruments which derive their value from some other
financial instrument or variable. They can be divided into exchange-traded derivatives and over-
the-counter (OTC) derivatives.22

Alternatively, financial instruments can be categorized by "asset class". They are -

1. Equity based (reflecting ownership of the issuing entity) or

2. Debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can
be further categorized into short term (less than one year) or long term.

Foreign Exchange instruments and transactions are neither debt nor equity based and belong in
their own category.

Further, instruments can be categorized into two types by its “market class”. They are-
a) Money Market Instruments-The important instruments traded in the money market are-

1. Call money /Notice money- Call money or call deposits are those money which are lent on
condition to repay on call. Notice money refers to the money lent and repaid on a certain
day’s notice from the lenders. The period of these transactions varies between overnight
and to a maximum of fourteen days.

22
Bose, Suchismita, 2005. “Securities Markets Regulation: Lessons from US and Indian Experience”, Money and
Finance, Jan-June, 83-124.
 20

2. Term money-Transactions between inter-bank participants for a period of more than 14

days are called term money.

3. Certificates of Deposits- Certificate of deposit is a money market instrument issued in

dematerialized form or as a usance promissory note, against funds deposited at a bank or
other eligible financial institution for a specified period. These are issued by scheduled
commercial banks (excluding regional rural banks and local area banks) and all India
financial institutions that have been permitted by the RBI. The maturity period of
certificates of deposits issued by the banks should not be less than 7 days and more than
one year while for certificates of deposits issued by the financial institutions is not less than
one year and more than three years.

4. Commercial Paper-Commercial paper (CP) is an instrument issued by corporates, primary

dealers and all India financial institutions to raise short-term resources .CPs are issued in
the form of promissory note for maturities between minimum of 7days and a maximum up
to one year from the date of issue. These can also be issued in dematerialized form through
any of the depositories approved by and registered with SEBI. Issuer of the CPs has to
obtain prior permission from the RBI for the issue. CP may be issued to individuals, banks,
other corporate bodies, Non-resident Indians and foreign institutional investors. CPs are
issued at a discount to the face value as determined by the issuer.

5. Bill Re-Discounting Schemes (BRDS) - This is a money market scheme whereby banks
may raise funds by issue of Usance promissory notes in convenient lots and maturities
matching the genuine trade bills discounted by them. This instrument promotes liquidity in
the money market. BRDS transaction can be done for a minimum period of 15 days and
maximum period of 90 days. The bank borrowing under this scheme issues a Usance
promissory note to the lender as well as a certificate to the effect that the bank holds
genuine bills equal to the amount of the transactions on its book.

6. Inter-Bank Participation Certificates (IBPCs)- IBPCs are instruments issued by scheduled

commercial banks only to raise funds or to deploy short –term surplus. IBPCs are of two
types- with risk sharing and without risk sharing. The minimum period shall be 91days and
maximum period 180 days in case of IBPCs on risk sharing basis and in the case of IBPCs
 21

under non-risk sharing basis the total period is limited to 90 days. IBPCs are not
transferable and cannot be redeemed before due date. Interest rates are determined between
the issuing bank and participatory bank.

7. Collateralized Borrowing and Lending Obligation (CBLO) - CBLO is a discounted

instrument available in electronic book entry form for the maturity period ranging from
one day to 90 days against securities which are placed with the Clearing Corporation of
India either as margin or otherwise. This is an instrument for those entities who have either
been phased out from inter-bank call money market or have been given restricted
participation in terms of ceiling on call borrowing and lending transactions and who do not
have access to the call money. Banks, financial institutions, NBFCs (Non- Bank Financial
Corpotrations), insurance companies, mutual funds, primary dealers, non-government
provident funds, corporates etc. are eligible to deal in CBLO.

8. Treasury Bills (T-bills) - Treasury bill is a very common short-term money market
instrument issued by the Government of India through the RBI. T-bill is issued at a maturity
period of 14 days, 28 days, 91 days, 182 days and 364 days. It is issued at a discount to its
face value which is usually Rs.100/-.The discount rate is determined by the RBI on the
basis of the bid submitted by the participants in the auction. Auctions are normally
conducted every week. T-bills are used by the RBI as credit control tool.

b) Capital market Instruments-Instrument issued to raise long term funds is called capital market
instruments.

Bonds are debt instruments issued by corporate bodies, governments or development financial
institutions to raise long term finance. These are fixed interest bearing instruments. They can be
issued with or without security. Bonds are negotiable instruments governed by the law of contract
and are generally transferable by endorsement.

Debentures- A debenture is also a debt instrument issued by a company for raising funds from the
public and institutions and offers to pay interest on the funds borrowed by the company. The
maturity of these instruments ranges between one to ten years. Debentures are governed by
provisions of the company law and are transferable only by registration. On the basis of security,
debentures can be classified as secured (secured by a charge on the fixed assets of the company)
 22

and Unsecured (not secured by any charge on assets). On the basis of convertibility, they can be
classified as Non-convertible, Partly convertible, Fully Convertible, and Optionally Convertible.

Equity Shares- According to the Companies Act, 1956, equity share is a part of the total capital of
the company. Equity shareholders entitled for a share of profit (Dividend) of the company and the
voting right. However, they also bear the risk of corporate performance. Shares are ownership
instruments but transferable. Shares are issued by the companies to raise funds required for long
term in the primary capital market while the secondhand shares are traded in the secondary market
through stock exchanges.

Preference Shares- Preference shares are the shareholders who assume only limited risks and
entitled to a predetermined dividend .They have no voting rights. Holders of preference shares
enjoy the preference to receive their capital over the equity shareholders. These instruments are
issued when there is a need for long term funds and at the same time shareholders do not want to
dilute the ownership in the company. Though these types of shares are marketable, they are not
widely traded on account of a fixed dividend.

Global Depository Receipts (GDR) - Global Depository Receipts, also known as GDRs, are
internationally traded equity instruments issued against equity shares .They represent a fixed ratio
of Indian shares quoted on BSE (Bombay Stock Exchange). GDRs are issued by international
depository and denominated in US Dollars. They are negotiable certificates and they are freely
traded in the overseas financial markets including Europe and USA.

American Depository Receipts (ADR)-American Depository Receipts, popularly called ADRs are
similar kind of instrument like GDR. However, ADRs are traded in US markets mostly. They are
denominated in US Dollars. These instruments are issued in accordance with the scheme for issue
of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipt
Mechanism) Scheme, 1993 and guidelines issued by the Central Government there under from
time to time.
IV. Financial Services

The development of a sophisticated and matured financial system in the country, especially after
the early nineties, led to the emergence of a new sector. This new sector is known as financial
services sector. Its objective is to intermediate and facilitate financial transactions of individuals
 23

and institutional investors. The financial institutions and financial markets help the financial
system through financial instruments. The financial services include all activities connected with
the transformation of savings into investment. Important financial services include lease financing,
hire purchase, installment payment systems, merchant banking, factoring, forfeiting etc.

The industry that has grown up to persuade people to put their money into investment and which
provides the facilities for doing so is called the “Financial Services Sector”. Simply put, all types
of activities involved in the transformation of surplus into investments, transfer of financial
resources, financial innovation are called financial services. The scope of the financial services is
very wide, unlimited and dynamic. However, banking services are not covered under financial
services because of their independent legal interpretation. 23

Financial Services may be divided into two groups - Fund based activities and Non-fund-based
activities.
Fund-based activities

1. Leasing
2. Hire Purchase
3. Venture Capital
4. Consumer Financing
5. Underwriting or investment in securities
6. Dealing in money market
7. Dealing in Forex market
8. Real Estate Financing
9. Housing Finance
10. Insurance
11. Mutual Funds etc.

Non-fund based activities

These financial services do not directly involve funds –

23
Ghosh, A., 2006, “Determination of Finacial Services in An Emerging Economy: Evidence from India”, Emerging
Markets Finance and Trade, Vol. 42, No. 3, 66-90.
 24

1. Merchant banking(issue management, placement of securities)

2. Portfolio Management

3. Industrial Investment Consultancy and Project Advisory Services

4. Broking and Portfolio Investment Services

5. Risk management

6. Bill Discounting

7. Factoring

8. Depository and Custodian services

9. Credit rating etc.

Conclusion
India has a financial system that is regulated by independent regulators in the sectors of banking,
insurance, capital markets, competition and various services sectors. In a number of sectors
Government plays the role of regulator.
 25

Ministry of Finance, Government of India looks after financial sector in India. Finance Ministry
every year presents annual budget on February 28 in the Parliament. The annual budget proposes
changes in taxes, changes in government policy in almost all the sectors and budgetary and other
allocations for all the Ministries of Government of India. The annual budget is passed by the
Parliament after debate and takes the shape of law.

Reserve bank of India (RBI) established in 1935 is the Central bank. RBI is regulator for financial
and banking system, formulates monetary policy and prescribes exchange control norms. The
Banking Regulation Act, 1949 and the Reserve Bank of India Act, 1934 authorize the RBI to
regulate the banking sector in India.

India has commercial banks, co-operative banks and regional rural banks. The commercial banking
sector comprises of public sector banks, private banks and foreign banks. The public sector banks
comprise the 'State Bank of India' and its seven associate banks and nineteen other banks owned
by the government and account for almost three fourth of the banking sector. The Government of
India has majority shares in these public sector banks.

India has a two-tier structure of financial institutions with thirteen all India financial institutions
and forty-six institutions at the state level. All India financial institutions comprise term-lending
institutions, specialized institutions and investment institutions, including in insurance. State level
institutions comprise of State Financial Institutions and State Industrial Development Corporations
providing project finance, equipment leasing, corporate loans, short-term loans and bill
discounting facilities to corporate. Government holds majority shares in these financial
institutions. Non-banking Financial Institutions provide loans and hire-purchase finance, mostly
for retail assets and are regulated by RBI.

Insurance sector in India has been traditionally dominated by state owned Life Insurance
Corporation and General Insurance Corporation and its four subsidiaries. Government of India has
now allowed FDI in insurance sector up to 26%. Since then, a number of new joint venture private
companies have entered into life and general insurance sectors and their share in the insurance
market in rising. Insurance Development and Regulatory Authority (IRDA) is the regulatory
authority in the insurance sector under the Insurance Development and Regulatory Authority Act,
1999.
 26

RBI also regulates foreign exchange under the Foreign Exchange Management Act (FERA). India
has liberalized its foreign exchange controls. Rupee is freely convertible on current account. Rupee
is also almost fully convertible on capital account for non-residents. Profits earned, dividends and
proceeds out of the sale of investments are fully repatriable for FDI. There are restrictions on
capital account for resident Indians for incomes earned in India.

Securities and Exchange Board of India (SEBI) established under the Securities and Exchange
aboard of India Act, 1992 is the regulatory authority for capital markets in India. India has 23
recognized stock exchanges that operate under government approved rules, bylaws and
regulations. These exchanges constitute an organized market for securities issued by the central
and state governments, public sector companies and public limited companies.

The Stock Exchange, Mumbai and National Stock Exchange are the premier stock exchanges.
Under the process of de-mutualization, these stock exchanges have been converted into companies
now, in which brokers only hold minority share holding. In addition to the SEBI Act, the Securities
Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the stock markets.

Suggestions
India’s financial system holds one of the keys, if not the key, to the country’s future growth
trajectory. The financial system’s ability to efficiently intermediate domestic and foreign capital
into productive investment and to provide financial services to a vast majority of households will
influence economic as well as social stability. While India’s financial institutions and regulatory
 27

structures have been developing gradually, the time has come to push forward the next generation
of financial reforms. The needs of a growing and increasingly complex market-oriented economy,
and its rising integration with global trade and finance, call out for deeper, more efficient and well-
regulated financial markets. Notwithstanding concerns about its depth and efficiency, the financial
system seems to have enabled rapid growth and relatively moderate inflation. Arguably, it must
be getting something right.

Why fix what ain’t broke? There are three main reasons.

First, the financial system is actually not working well in terms of providing adequate services to
the majority of Indians, meeting the large-scale and sophisticated needs of large Indian corporates,
or penetrating deeply enough to meet the needs of small and medium-sized enterprises. All of this
will inevitably become a barrier to high growth.

Second, the financial sector—if unleashed but with proper regulation--has the potential to generate
millions of much-needed jobs and, more important, have an enormous multiplier effect on
economic growth and the inclusiveness of the financial system.

Third, in these uncertain times, financial stability is more important than ever to keep growth from
being derailed by shocks hitting the system, especially from abroad.

Even if one accepts all of this, why now? After all, the world’s deepest and most sophisticated
financial market seems to be imploding, and taking down many foreign financial institutions with
it. Perhaps it is time for India to batten down the hatches, insulate itself from global finance, and
not venture into sophisticated but apparently risky products. This is the wrong lesson to draw from
the U.S. sub-prime mess. The right lesson is that markets and institutions do succumb occasionally
to excesses, which is why regulators have to be vigilant, constantly striking the right balance
between attenuating risk-taking and inhibiting growth. Similarly, the right lesson to be drawn from
the Asian crisis is not that foreign capital or financial markets are inherently destabilizing, but that
weak legal frameworks and toothless regulation, especially if coupled with public corruption and
weak corporate governance, can spell trouble.

Financial sector reforms that lead to well-functioning competitive markets can reduce these
vulnerabilities. Indeed, the U.S. equity, government debt, and corporate debt markets remain
resilient, despite being close to the epicenter of the crisis. But a robust financial system is not much
 28

good if most people don’t have access to it. Financial inclusion, which means providing not just
basic banking but also instruments to insure against adverse events, is a key priority in India. The
absence of access to formal banking services, which affects more than one-third of poor
households, leaves them vulnerable to informal intermediaries such as moneylenders.
Government-imposed priority-sector lending requirements and interest rate ceilings for small loans
have ended up restricting rather than improving broad access to institutional finance. Banks have
no incentive to expand lending if the price of small loans is fixed by fiat.

Consequently, nearly half of the loans taken by those in the bottom quarter of the income
distribution are from informal lenders at an interest rate above 36 percent a year, well above the
mandated lending rate. The solution is not more intervention but more competition between formal
and informal financial institutions and fewer strictures on the former. With so many difficult
challenges, what is the way to proceed?

A hundred small steps, many of them less controversial but still requiring some resolve on the part
of policymakers, could get the process of reforms going and build up momentum for the bigger
challenges that lie ahead. For instance, converting trade receivable claims to electronic format and
creating a structure to allow them to be sold as commercial paper could greatly boost the credit
available to small and medium enterprises. We believe that if other policies are in sync, financial
sector reforms could add significantly to economic growth and also make a major contribution to
the sustainability of this growth, in both the economic and political dimensions. The absence of
reforms would not only represent a lost opportunity but also a huge source of risk for the economy.
The time to act is now.

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Working paper, The Wharton School.

 29

 Kumbhakar, S.C. and Sarkar, S., 2003, “Deregulation, Ownership, and Productivity

Growth in the Banking Industry: Evidence from India”, Journal of Money, Credit, and

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 30

 Bhaumik, Sumon K. and Jenifer Piesse, 2003, “Are Foreign Banks Active in Emerging

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 Ghosh, A., 2006, “Determination of Finacial Services in An Emerging Economy: Evidence

from India”, Emerging Markets Finance and Trade, Vol. 42, No. 3, 66-90.
31